Decentralized finance, or DeFi, refers to financial applications built on blockchains like Ethereum that operate without a traditional intermediary such as a bank or broker. This guide covers the basics and the risks.
What DeFi applications actually do
| Type | What it replaces | Example function |
|---|---|---|
| Decentralized exchanges (DEXs) | A traditional stock or crypto exchange | Swapping one token for another directly, peer-to-peer via code |
| Lending protocols | A bank loan | Lending or borrowing crypto against collateral, set by smart contracts |
| Staking platforms | A savings account | Locking crypto to earn yield, often from network rewards |
How DeFi removes the intermediary
Instead of a company processing your trade or loan, DeFi applications use smart contracts, self-executing code on a blockchain, to handle the transaction automatically according to pre-set rules. No central party holds your funds in the traditional sense.
Risks specific to DeFi
- Smart contract risk: bugs or exploits in the underlying code can result in permanent loss of funds
- No customer support: there is typically no company to call if something goes wrong
- Impermanent loss: providing liquidity to a DEX can result in a loss relative to simply holding the assets, depending on price movements
- Regulatory uncertainty: DeFi’s legal status is still evolving in most countries
Key takeaways
- DeFi applications use smart contracts to replace traditional financial intermediaries.
- Removing the intermediary also removes traditional safety nets like customer support and deposit insurance.
- Smart contract risk and impermanent loss are risks specific to DeFi that traditional finance does not carry.
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